The process of withholding taxes from paychecks is an important means of raising revenue for the federal government, as it provides it with income throughout the entire year to fund important programs. Most forms of wages are subject to withholding. However, profit-sharing plans are a different type of compensation, and so there is no withholding when the employer contributes to the plan. Withholding only applies when the member withdraws his share of the funds.
The federal government requires individuals to pay certain taxes throughout the year, as opposed to paying one lump sum at the end of the reporting period. The way the Internal Revenue Service achieves this is by having employers withhold amounts from their employee’s wages, which they then deposit with the government. Each type of tax deducts a set percentage from the employee’s wages and requires the employer to provide a contribution as well. There are three types of federal taxes that are subject to withholding. The first is for federal income tax. These amounts are the basis for whether a person gets a refund or not, as the IRS would give back the excess money it collected during the year from the person’s wages. The second group of withholding is used to fund Social Security and Medicaid. The final type of withholding is used to fund federal unemployment insurance.
A profit-sharing plan is an employer-sponsored retirement option for employees. Every year, the employer makes a contribution to the fund based on whatever criteria she sees fit to use. The contribution is then divided among the employees who are members of the plan, based on an established formula. A member can withdraw her share of the plan whenever she wants, but will suffer a 10 percent penalty if she withdraws her funds before she turns 59-1/2.
Profit-Sharing and Withholding
Contributions made by employers to employee retirement plans are not subject to any withholding taxes. However, when an employee withdraws funds from the plan, it is subject to income tax withholding, but not Social Security, Medicare or unemployment taxes. The amount that is withheld on plan withdrawals for income tax purposes is generally 20 percent.
Tax Tips and Disclaimer
For complex returns, consult with a tax professional, such as a certified public accountant or licensed attorney, as he can best address your individual needs. Keep your tax records for at least seven years, to protect against the possibility of future audits. Every effort has been made to ensure this article’s accuracy, but it is not intended to be legal advice.
- IRS.gov; Publication 15 – (Circular E) Employer’s Tax Guide; 2011
- Taxpayer Advocate Service, "Vol. 2, TAS Research and Related Studies: A Conceptual Analysis of Pay-As-You-Earn (PAYE) Withholding Systems as a Mechanism for Simplifying and Improving U.S. Tax Administration," Page 11. Accessed April 1, 2020.
- Internal Revenue Service. "Understanding Taxes -- Theme 2: Taxes in U.S. History." Accessed April 1, 2020.
- Internal Revenue Service. "Form W-4," Accessed April 1, 2020.
- Tax Foundation. "State Individual Income Tax Rates and Brackets," Pages 1–10. Accessed April 1, 2020.
- Social Security Administration. "Contribution And Benefit Base," Accessed April 1, 2020.
- U.S. Congress. "H.R. 748 - CARES Act." Accessed April 1, 2020.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.